While the report clarifies several regulatory matters pertaining to the microfinance sector, it has also invited a number of comments on the specific recommendations (e.g. this critique in the Mint). The purpose of this post, however, is to highlight the recommendations of the committee on corporate governance and financing in microfinance institutions.
By way of background, the idea of microfinance was initially spearheaded by self-help groups and other non-profit institutions. However, with the need to create a scalable model, the sector began attracting private capital through market-based mechanisms that required the creation of for-profit enterprises. This witnessed the emergence of the traditional corporate set up where companies were incorporated to carry on microfinance business. This business is financed through traditional means of corporate finance: bank loans, investments from private equity or venture capital investors, and increasingly through securities offerings to the public.
The prevalence of for-profit companies raising finance from the markets gives rise to a peculiar corporate governance issue: a dichotomy of objectives in the microfinance sector. On the one hand, microfinance institutions are established with social goals, i.e. the reduction of poverty, and in that sense need to cater to the interests of their stakeholders, who are the poorer and less-privileged sections of society that avail of their services as customers. On the other hand, raising finances from the financial markets imposes pressures to constantly deliver returns to the markets, thereby incentivizing managements to earn profits. A delicate balancing exercise is involved in this addressing this dichotomy. Apart from mandatory norms imposed by regulators as to the manner in which microfinance companies carry on business, the nature of management and governance of these companies does have a significant role to play. Unfortunately, the governance issues are difficult to grapple with, and there is no direction is sight yet.
In this context, the Malegam committee recognises the importance of corporate governance in the microfinance sector, and makes recommendations. The relevant portion of the report is extracted below:
16. Corporate Governance
16.1 MFIs have twin objectives, namely to act as the vehicle through which the poor can work their way out of poverty and to provide reasonable profits to their investors. These twin objectives can conflict unless a fair balance is maintained between both objectives. This makes it essential that MFIs have good systems of Corporate Governance.
16.2 Some of the areas in which good corporate governance can be mandated would be:-
a) the composition of the board with provision for independent directors
b) the responsibility of the board to put in place and monitor organisation level policies for:-
(i) the growth of the loan portfolio including its dispersal in different regions
(ii) the identification and formation of joint liability groups
(iii) borrower training and education programmes
(iv) credit and assessment procedures
(v) recovery methods
(vi) employee code of conduct
(vii) employee quality enhancement programmes
(viii) compensation system for employees including limits on variable pay and the limit therein on weightage for business development and collection efficiency
(ix) customer grievance procedures
(x) internal audit and inspection
(xi) whistle blowing
(xii) sharing of information with industry bodies
c) disclosures to be made in the financial statements including:
(i) the geographic distribution of the loan portfolio, both in terms of number of borrowers and outstanding loans
(ii) analysis of overdues
(iii) the average effective rate of interest, the average cost of funds and the average margin earned
(iv) analysis of the outstanding loans by nature of purpose for which loans were granted
(v) composition of shareholding including percentage shareholding held by private equity
16.3 We would, therefore, recommend that every MFI be required to have a system of Corporate Governance in accordance with rules to be specified by the Regulator.
While the recommendations do well in identifying the dichotomy between social and financial objectives of microfinance companies, they are somewhat cursory in nature in the absence of a detailed conceptual discussion and analysis of the issues involved. That is perhaps understandable because the committee was operating within the aegis of the RBI as a financial regulator. Since corporate affairs fall within the purview of the Ministry of Corporate Affairs (for unlisted companies) and SEBI (for listed companies), a more detailed consideration may have to await their intervention. Since microfinance activity has witnessed exponential growth in India in the last few years, this is an opportune time to consider corporate governance of microfinance through a different paradigm (especially for companies that are accessing the public markets), and it is not sufficient to rely on conventional models of corporate governance.
Apart from microfinance companies, the investors and financiers of such companies also have a significant role to play in this debate. If finance is provided on conventional terms, it is not too much for the investors and financiers to expect market-based returns, which skew the social objectives. Hence, there is need for socially responsible investments in this sector. The Malegam committee does take note of this issue and suggests measures as follows:
21 Funding of MFIs
21.1 It has been suggested that the entry of private equity in the microfinance sector has resulted in a demand for higher profits by MFIs with consequent high interest rates and the emergence of some of the areas of concern which have been discussed earlier.
21.2 Without expressing any opinion on the matter, it is necessary to understand the circumstances in which private equity has entered the sector. On the one hand, there was a huge unsatisfied demand for microfinance credit and on the other, there was a limitation on the capacity of not-for-profit entities to meet this demand. When for-profit entities emerged, microfinance was seen as a high-risk entity but venture capital funds are not allowed to invest in MFIs and private equity rushed in to fill this vacuum.
21.3 We believe it is necessary to widen the base from which MFIs are funded in respect of the Net Owned Funds needed for Capital Adequacy and for that purpose the following need to be examined.
a) It has been suggested that a “Domestic Social Capital Fund” may be permitted to be established. This fund will be targeted towards “Social Investors” who are willing to accept “muted” returns, say, 10% to 12%. This fund could then invest in MFIs which satisfy social performance norms laid down by the Fund and measured in accordance with internationally recognized measurement tools.
b) MFIs should be encouraged to issue preference capital which carries a coupon rate not exceeding 10% to 12% and this can be considered as Tier II capital in accordance with norms applicable to banks.
21.4 We would, therefore, recommend that:
a) The creation of one or more “Domestic Social Capital Funds” may be examined in consultation with SEBI.
b) MFIs should be encouraged to issue preference capital with a ceiling on the coupon rate and this can be treated as part of Tier II capital subject to capital adequacy norms.